The IllLiquidity of the Canadian Repo Market

The Canadian Repo Market, also known as Lynx, is currently facing significant challenges due to illliquidity. But what exactly is a repo market, and why is this important? Let's break it down in simple terms.

What is the Repo Market?

Think of the repo market as a pawn shop for banks. When banks need short-term money, usually overnight, they put up collateral like deposits, bonds, mortgage-backed securities (MBS), or commercial real estate to borrow money from other banks. This system helps banks manage their short-term cash needs and ensures they can continue to operate smoothly.

The Role of the Bank of Canada (BoC)

The Bank of Canada (BoC) plays a crucial role in this market. However, the BoC is currently undergoing a process called Quantitative Tightening (QT). This means they are selling off much of their assets and not buying back bonds. The BoC's assets have dropped from a peak of $570 billion to $273 billion. This shift has led to an excess of bonds in the market, causing bond prices to drop and yields (interest rates) to increase due to the basic principles of supply and demand.

The Concentration of Money in Lynx

One of the biggest issues in Lynx right now is that 80% of the available money is held by just three banks. This is up from 67% last year. According to a CIBC report, the BoC's QT policy is removing liquidity from the repo market. Essentially, since the BoC is buying back fewer government bonds, there is less money circulating in the financial system.

Hoarding of Funds by Major Banks

These three banks are not freely lending their money to other banks in need. They are hoarding their funds, making the situation worse. This combination of the BoC's QT policy and the hoarding of money by these banks is causing severe issues for Lynx. The system has become illiquid, and this is pushing interest rates up.

Rising Interest Rates

Ideally, the interest rate charged by lending banks in Lynx should be roughly the BoC's overnight lending rate, which is currently 4.75%. However, due to the current illiquidity in Lynx, rates have deviated and increased to about 4.80% and higher. These higher rates in Lynx are causing higher lending rates at some banks, which can impact the broader economy.

Emergency Intervention by the BoC

In response to this illiquidity, the BoC had to step in on Friday and inject $12.6 billion into the system. This emergency intervention was necessary to stabilize the market and ensure that banks had enough liquidity to meet their short-term funding needs.

Key Questions

This situation raises two important questions:

1. Why do three banks hold 80% of the available funds in Lynx?

2. Why are these banks hoarding the funds?

The second question is more pressing. One possible reason for the hoarding is that the securities being offered as collateral are not attractive or valuable enough to the lending banks. They might perceive these assets as too risky or not worth the exchange.

Conclusion

The current illiquidity in the Canadian Repo Market, or Lynx, is a significant issue. The combination of the BoC's QT policy and the hoarding of funds by major banks is pushing interest rates up and creating challenges for the financial system. By understanding these dynamics, we can better appreciate the complexities of our financial system and the impact of monetary policies.